What should I do with my next saved dollar? Where should I be saving?

Optimizing Your Savings Strategy

Discover a logical step-by-step guide on how to prioritize your savings. The right decision may help you optimize your net savings.

Problem

Deciding where to allocate your savings can be overwhelming. Should you build an emergency fund, save for retirement, pay off debt, or take advantage of benefits like an Employee Stock Purchase Plan (ESPP)? With so many options, it’s easy to feel stuck or unsure.

Effect

Without a clear plan, your hard-earned money might not work as effectively as it could. This uncertainty can lead to missed opportunities, wasted resources, and slower progress toward your financial goals. You could be paying unnecessary interest, losing out on tax advantages, or delaying wealth-building altogether.

Solution

That’s where a savings waterfall comes in—a logical, step-by-step guide that makes prioritizing your savings easier. Picture a series of buckets under a waterfall: you "fill" the first bucket (your top priority), and any leftover money flows into the next.

By using this approach, you can optimize your net savings, tackle your financial goals and ensure every dollar is put to its best use.

Key Takeaways

1. Build an Emergency Fund
   Create a safety net by saving 3-6 months of living expenses in a high-yield savings account for unexpected costs like car repairs or medical bills.

2. Prioritize Retirement Contributions

   • Maximize employer 401(k) matching contributions—it's free money.

   • Consider adding more to your 401(k) or Roth IRA after tackling other priorities, using strategies like a backdoor Roth if needed.

3. Tackle High-Interest Debt
   Focus on aggressively paying off debts with interest rates above 7%, while maintaining minimum payments on lower-interest debts.

4. Use Specialized Accounts for Tax Benefits

   • HSA: Triple tax benefits for medical expenses and long-term growth.

   • 529 Plan: Tax-advantaged savings for education expenses, with flexibility for changing beneficiaries.

5. Invest Smartly Beyond Retirement Accounts

   • Use a brokerage account for flexibility, diversification, and tax efficiency (e.g., tax-loss harvesting and long-term capital gains).

   • Consider participating in an ESPP to buy discounted company stock, balancing short-term profits with long-term investment strategy.

Build Your Safety Net: The Emergency Fund

Life happens—your car breaks down or the furnace stops working in the dead of winter. An emergency fund is your financial safety net for these curveballs.

Here's What You Can Do:

• Set a Goal: Aim to save enough to cover the longer of 6-12 months of your living expenses, or the time it takes you to find a job if you were to be laid off.

• Choose the Right Spot: Keep this money in a high-yield savings account so it's accessible but still earning some interest. I keep my portion of the emergency fund within my taxable brokerage account but reserved in VMFXX (Vanguard’s Money Market Mutual Fund). It has its pros and cons but it works for me.

Matching Contributions From Your Employer Retirement Plan

If your employer offers a retirement plan like a 401(k) with a matching contribution, it's like getting free money added to your salary.

Action Steps:

• Contribute Enough to Get the Match: If your employer matches up to 3% of your salary, make sure you're contributing at least that much.

• Regardless of whether you choose traditional or Roth contributions for your portion, employer matching contributions are typically made on a pre-tax basis.

Tackle High-Interest Debt: Free Yourself Faster

High-interest debts, like credit cards, can feel like a ball and chain on your finances.

What to Do:

• Identify the Culprits: Look for debts with interest rates above +7%.

• Make a Plan: Focus on paying these off aggressively while making minimum payments on lower-interest debts.

Health Savings Account (HSA)

An HSA isn't just for medical expenses; it's a powerful savings tool with triple tax benefits.

Steps to Take:

• Check Eligibility: You need a high-deductible health plan to contribute.

• Contribute the Max: For 2025, that's $4,300 for individuals and $8,550 for families (source: Rev. Proc. 2024-25 IRS).

• Think Long-Term: If you can, invest these funds to grow over time.

Invest in a Roth IRA

A Roth IRA allows your money to grow tax-free, and you won't pay taxes on withdrawals in retirement.

Here's How:

• Check Income Limits: Make sure you qualify based on your income.

• Consider a Backdoor Roth: If you earn too much, there's a workaround—ask me how!

• Contribute Up to the Limit: For 2025, that's $7,000, or $8,000 if you're over 50.

Source: IRS - Retirement Topics

Max Out Employer Retirement Plans

Once you've got the match and tackled other priorities, consider contributing even more to your retirement accounts.

Action Plan:

• Know the Limits: You can contribute up to $23,500 to your 401(k) in 2025, or $31,000 if you're over 50.

• Explore Other Options: If available, consider after-tax contributions or a Mega Backdoor Roth.

Invest in Your Company’s ESPP

If your company offers an ESPP, you can buy company stock at a discount, which can be a smart move.

What You Should Do:

• Understand the Deal: Discounts are usually around ~10%.

• Decide to Hold or Sell: You can sell the stock immediately for a quick profit or hold onto it if you believe in the company's long-term prospects.

• Be Mindful of Taxes: Holding the stock for a certain period can have tax advantages. Keeping it for over 1 year will give you long-term capital gains treatment but you are more susceptible to the volatility of the stock.

Use a 529 Plan for Tax-Advantaged Education Funding

529 plans offer significant tax advantages when saving for qualified education expenses, making them an effective way to prepare for future education costs for your children or even yourself.

• Select a Plan: Research and choose a 529 plan that fits your needs. While many opt for their state's plan to receive state tax benefits, you're free to select any state's plan.

• Tax-Free Growth: Contributions grow tax-deferred, and withdrawals for qualified education expenses are tax-free federally and often at the state level. Some states offer tax deductions or credits for contributions to their own 529 plans.

• Gift Tax Considerations: Technically, there's no annual contribution limit, but contributions are subject to gift tax rules.

• Qualified Expenses: Funds can be used for tuition, fees, books, and even room and board.

• Changing Beneficiaries: If the original beneficiary doesn't need the funds, you can transfer the account to another qualified family member.

• Plan Ahead: Estimate future education costs to avoid overfunding the account.

Non-Deductible Contributions to Retirement Accounts

Why would someone save money in a non-deductible way into a Traditional IRA over a taxable brokerage?

To me there are only four valid answers:

1. Tax-deferred growth: This is the primary advantage. While you don't get a tax break upfront for contributions, the money grows tax-deferred until retirement. This can be significant over time, especially for those in higher tax brackets or expecting to be in a lower tax bracket in retirement. In a taxable brokerage account, you pay taxes annually on dividends and capital gains, which hinders compounding.

2. Creditor protection: Retirement accounts often offer some level of protection from creditors in case of bankruptcy or lawsuits. This protection can vary by state and account type, but it's generally stronger than the protection offered for assets in a taxable brokerage account.

3. Backdoor Roth IRA strategy: As you mentioned, a non-deductible traditional IRA can be a crucial stepping stone to a Roth IRA. This "backdoor" strategy allows high-income earners who are ineligible to contribute directly to a Roth IRA to still benefit from Roth's tax-free growth and withdrawals in retirement.

4. Estate planning: While not a primary reason, the tax-deferred nature of these accounts can have estate planning benefits, especially if beneficiaries are in a lower tax bracket than the account holder.

Invest in a Brokerage Account

A taxable brokerage account offers investment flexibility with no contribution limits or withdrawal restrictions. By employing tax-loss harvesting, you can reduce your taxable income each year.

• Open an Account: Select a reputable brokerage firm that aligns with your investment preferences.

• Invest Wisely by diversifying your portfolio through a mix based on your risk tolerance and financial goals. Choose tax-efficient investments such as index funds or ETFs, which are generally more tax-efficient than actively managed funds.

• Hold Investments Over a Year: Benefit from lower long-term capital gains tax rates by holding assets for more than one year.

• Utilize Tax-Loss Harvesting by identify and realizing those losses (in other words, selling those investments that are losing money) to generate capital losses. Then, offsetting those losses with capital gains from other investments.

• Ordinary Income: Deduct up to $3,000 of excess losses against your ordinary income annually.

• Carry Forward: Any unused losses can be carried forward to future tax years.

• Avoid Wash Sales: Do not repurchase the same or substantially identical securities within 30 days before or after the sale to ensure the losses are deductible.

FAQs About Waterfall Savings Strategy

I can't afford to do all this right now. Where do I start?

Start at the top of the waterfall. Build your emergency fund first, then move on to getting the employer match on your retirement plan. Take it one step at a time.

Should I pay off my mortgage early or invest extra money?

It depends on your interest rate and personal comfort. If your mortgage rate is low, investing might give you a better return. But if being debt-free feels better to you, that's a valid choice too.

How do I juggle saving for retirement and other goals like buying a home?

Prioritize based on what's most important to you and your timelines. The savings waterfall is flexible—it's okay to adjust it to fit your life.

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